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Chapter 3 Insurance Companies.docx

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FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 3 Insurance Companies  By accepting premiums, insurance companies promise policyholders compensation if certain events occur  Policies represent financial liabilities to insurance company  Classified into two major groups: o Life insurance provides protection against possibility of untimely death, illnesses, and retirement o Property insurance protects against personal injury and liability such as accidents, theft, and fire LIFE INSURANCE COMPANIES Size, Structure, and Composition of the Industry  Demutualization – conversion from a mutual insurance company own by policyholders to a stockholder-controlled insurance firm o Allows insurance firm to gain access to equity markets in order to raise additional capital for future business expansions and compete with larger banking industry  By pooling risk, life insurance transfers income-related uncertainties from the insured individual to a group  Two problems face life insurers and property and casualty insurers: 1. Moral hazard – insured person or company is encouraged to take more risks because the downside risk has been transferred to the insurer 2. Adverse selection – tendency for higher-risk individuals to carry higher levels of insurance, making the overall risk in the insurance pool higher than in the general population  Insurance companies deal with this by establishing different pools of population based on health and related characteristics to determine probability of loss and determining pay out  Actuarially priced – insurance premium based on perceived risk of insured Life Insurance  Four basic classes of life insurance: individual life, group, industrial life, and credit life o 63% of total life insurance was for individual life insurance; remaining was group life insurance Individual Life  Five basic contractual types; first three are traditional forms of life insurance, and last two are newer contracts 1. Term life – individual receives a payout contingent on death during coverage period  Pure life insurance, with no savings element attached 2. Whole life – protects individuals over an entire lifetime as long as premiums are made, in return for periodic or level premiums and receives face value of life insurance contract on death  Whole life has savings element as well as pure insurance element 3. Endowment life – guaranteed payout to beneficiaries if death occurs during some endowment period; insured person who lives to endowment date receives face amount of policy  Combines pure (term) insurance element with a savings element 4. Variable life – invests fixed premium payments in mutual funds of stocks, bonds, and money market instruments, thus value of policy increases or decreases with asset returns of mutual fund in which premiums are invested depending on risk preference 5. Universal life and variable universal life – allows premium amounts and maturity of life contract to be changed by the insured so savings and investment component reflect market returns Group Life  Covers a large number of insured persons under a single policy usually issued by corporate employers  Policies can be contributory (both employer and employee cover share of the employee’s cost of insurance) or non- contributory (where employee does not contribute to cost of insurance) Industrial Life  Weekly payments directly collected by representatives of the company Credit Life  Sold to protect lenders against a borrower’s death prior to repayment of debt contract such as mortgage or car loan  Face amount of insurance policy reflects outstanding principal and interest on the loan FIN701 Financial Institutions Management Other Life Insurer Activities  Other activities of life insurance involve: i. Investment and retirement products (annuities, pension plans, RRSPs, and RRIFs)  Annuities represent different methods of liquidating a fund, such as paying out fund’s proceeds  Builds up a fund whose returns are tax-deferred; not subject to capital gains taxes on their investments  Annuity sales represent 45.5% of total premium income ii. Accident and health insurance  Protects against morbidity or ill health by providing additional coverage, through supplementary health insurance plans provided by employee benefits  Total health insurance premiums were 34.9% of total premium income Balance Sheet and Recent Trends Assets  Due to long-term nature of liabilities (long-term life insurance policyholders’ claims) and need to generate competitive returns on savings elements, life insurance companies concentrate asset investments with longer maturity (EX. Bonds, equities, and government securities)  Policy loans – loans made to policyholders using their policy as collateral  Insurance companies purchase mortgages in secondary market as investment securities and thus, must measure and manage credit risk, interest rate risk, and other risks  Offer shares in investment funds called segregated funds – investment fund held and managed separately by life insurance companies – that are similar to mutual funds offered by FIs o Must return minimum percentage (75% or more) of capital invested to investor at maturity, reducing risk of capital loss o Funds are creditor proofing assets – cannot be claimed by creditors in bankruptcy Liabilities  Large portion represents actuarial liabilities – based on actuarial assumptions regarding insurers’ expected future liability commitments to pay out of present contracts, including death benefits, matured endowments, and cash surrender values of policies o Actuarial assumptions underlying policy reserves normally conservative, but underwriting life insurance is risky because of unexpected fluctuations in future required payouts can occur o To meet with unexpected losses, life insurer holds capital and surplus reserve funds Regulations  OSFI guidelines include minimum capital and surplus requirements, innovative instruments, large exposure limits, securities lending, asset securitization, derivatives best practices, money laundering, outsourcing, accounting and reporting requirements  OSFI guidelines with standards for sound business and financial practices specifically for life insurance companies that address capital management, credit risk management, foreign exchange risk management, interest rate risk management, and liquidity management  Canadian Life and Health Insurance Compensation Corporation (Assuris) is private, non-profit corporate that is financed by life and health insurance companies to provide guarantee, subject to limits, of existing life insurance policies, accidents and sickness policies, and annuity contracts in the event of the bankruptcy of an insurance company PROPERTY AND CASUALTY INSURANCE Size, Structure, and Compensation of the Industry  Property and causality insurance industry spreads risk of personal or business loss over many policyholders  Divided among primary insurers – originators of insurance policies – and reinsurers –
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